brexit

Puzzling over Brexit

Ben Kumar, Investment Manager

Brexit is likely to dominate headlines for some time to come. But what are we doing to help ensure that we help protect portfolios as the headlines hit markets? Ben Kumar explains the latest 7IM thinking.

Brexit
Like the rest of the country, at 7IM we are unsure of where the Brexit negotiations will end up, when things will be settled, or even who will be involved. With such uncertainty, we prefer to be insulated against large moves either way in the value of the Pound. Here, we discuss why and how we’ve done so.

Just over two years after the EU Referendum, things are some-what …mixed. On the one hand, the FTSE 100 is more than 20% higher, economic growth is positive and interest rates are starting to leave emergency territory. On the other hand, Sterling remains close to all-time lows, the domestic political situation is incredibly fragile, and negotiations with the EU seem to be stalled. The above factors give plenty of ammunition to both sides of the Remain/Leave argument. However, with no clear answer yet, perhaps the most frequently asked question in meetings at the moment is: “What does 7IM think about Brexit?”

As an investment manager, it is important to try to put personal views aside when thinking about our clients’ assets – we are not really in the business of trying to predict what will happen but rather prepare for a set of scenarios. With regard to Brexit - this means looking to be able to guard our clients from large moves in Sterling, in either direction. This allows the rest of their portfolios to stay invested and continue to generate returns over the long term. So, rather than trying to puzzle out the exact shape of the final deal with the EU, we take a different approach...

Instead, we try to look at the broad shape of the most likely outcomes, and the implications that these could have for the value of Sterling. With these figures in mind, we can then stress-test the portfolios and get an idea of the impact of any large moves. We used this kind of scenario analysis two years ago, and it helped us to be prepared for the referendum outcome. The situation is a little different today than it was a couple of years ago, with a number of important dates and decisions, rather than just one vote, but the approach is still useful.

“As an investment manager, it is important to try to put personal views aside when thinking about our clients’ assets – we are not really in the business of trying to predict what will happen but rather prepare for a set of scenarios.”

We believe that there are three potential outcomes for the shape of Brexit negotiations over the next six to twelve months: Keep Kicking the Can; Shock Remain; or No Deal. Each is briefly described below:

Keep Kicking the Can – 75% probability
This is where the only agreement that is reached…is to keep on trying to reach an agreement. Through whatever legal and political mechanism is necessary, the EU and the UK Government would extend the deadline (again) for negotiations. Nothing changes from the current state of the world while the talks continue. This is good for a lot of things, such as existing trade and freedom of movement, but it is bad given that it also preserves uncertainty for businesses, investors and individuals. The weak UK Government is only half of the reason for this to come true; the EU loves nothing more than to extend and pretend when it comes to difficult situations. Here, the value of Sterling is likely to be driven as much by global affairs as it is by any progress on Brexit. We believe that this is most likely the world in which we are going to exist, and for quite some time. Sterling exposure is less important here, as there is likely to be a lot of noise, but little direction. Instead, we are better off looking at the global picture for equities and bonds.

No Deal – 20% probability
Here, the UK exits the EU without a deal of any kind in place, transitional or otherwise. Negotiations may well continue, but the EU link is severed. This is a scenario which would come as a surprise, but is likely to result from a lack of compromise by both the UK and the EU, as both sides play hardball until it is too late. This is not as unlikely as it might seem. The Conservative government might believe that any concession in the Brexit negotiations could result in a vote of no confidence, another leadership contest and a general election. Any compromises by the EU also might not happen given the number of countries and interests involved. Sterling would fall in waves as key dates go by with no agreement, and then drop sharply once the final 29 March 2019 date is passed – perhaps a scale of movement similar to the immediate aftermath of the EU Referendum, of around 10-15%. Domestic UK equities would suffer here, and even the more international large caps would feel some pain. Global equity markets would probably shrug off the impact quite quickly, although European companies could be more exposed.

Shock Remain – 5% probability
This is where there is a sudden capitulation by the British government, resulting in an outcome that is basically the same as EU membership (or something akin to Norway). We believe this is unlikely. Progress towards some sort of agreement is going to be a drawn out affair, where the final outcome doesn’t become clear for a long time (Keep Kicking the Can). Even the intermediate steps towards a change in attitude don’t really remove the ambiguity. An announcement of a second referendum might well be seen as a positive, but the outcome would not be a sure thing. Similarly, a general election carries with it uncertainty (what would a Labour party victory mean? Or a hung Parliament?). Sterling may see periods of strength, but until the ink has dried, a sustained rally would seem unlikely. If we did see a “Remain” type scenario, both domestic and international UK stocks would see a big boost from the removal of uncertainty, and other equity markets around the world might join in the fun for a short time.

What does this mean for our portfolios?
For portfolios, this leaves us in a position where our base case suggests that we should ignore Brexit over the medium term, as it will continue to rumble on and on. However, in the other two scenarios, the large moves in Sterling are worth thinking about. As such we have worked with the Investment Risk Team to develop stress tests that reflect asset price movements in the two non-base case scenarios described above.

In a No Deal scenario, the foreign currency exposure in our funds would be beneficial – we have around a third of our Balanced portfolios allocated to non-Sterling assets. Should we see a rerun of June 2016, we believe, our portfolio returns will see small positive returns.

In a Shock Remain scenario, whilst the value of our foreign currency assets would suddenly fall in Sterling terms, the accompanying rally in equities should be helpful in maintaining portfolio returns. If the situation plays out as we believe it would, again our portfolios should keep their value. Where we are able to, we have bought some options on Sterling that should further protect against a Sterling rally – adding to those positive returns.

In neither of these scenarios, however, are we aiming to provide spectacular results. Our scenario analysis and stress testing approach should help us to protect clients’ capital from shock events that impact Sterling. That leaves us free to focus on the global investment picture for the longer term.

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